Dr Bollard and the First Law of Holes
by Keith Rankin
29 November 2005
The First Law of Holes says "stop digging". It applies, universally, to anyone who's in a hole. And Dr Alan Bollard, Governor of the Reserve Bank of New Zealand certainly is in a hole.
So are the rest of us, although most of us don't know it yet. It is a hole dug for us by the Reserve Bank, while the Government sits back and watches with increasing concern but no obvious sense of panic.
The Reserve Bank blames New Zealand consumers and banks for digging the hole. And in a sense we are all digging. But only the Reserve Bank is in a position to stop the digging. The rest of us are simply obeying market forces; forces set in play by the Reserve Bank.
The New Zealand dollar is now at a record high. The TWI (trade-weighted index), the technically correct measure of the value of the kiwi dollar (measured against the four leading currencies of the world, plus the Australian dollar) is now at 72.8. Today we hit 0.95 against the Australian dollar, heading for parity by Christmas.
Before this month the post-float high for the TWI was 71.8. Before this year, the post-float high was 70.0 in February 1988. Five years ago the TWI was at 46, meaning the kiwi dollar has appreciated 58% in five years against all other currencies (ie including substantial rises against "strong" currencies like the Euro and the Pound). The "correct" TWI value is probably between 55 and 60.
When we floated our dollar in March 1985, we were assured that a floating currency automatically fixed the balance of payments problems that had hitherto dominated New Zealand's economic policymaking. So we quickly developed a mindset that the balance of payments didn't matter.
We learned before 1985 was over that this assurance was not true. The $NZ that was supposed to fall after the float, in fact rose. It rose because at that time we set our interest rates higher than any other comparable country.
The combination of high interest rates and a floating exchange rate significantly exacerbated our balance of payments' problems through until 1988. We then experienced our worst "financial crisis" ever, from 1988 to 1993. (The Great Depression of the early-1930s was a worse economic crisis, but was not a financial crisis as such in New Zealand, although it was a financial crisis in many other countries.)
For some reason we have not learned. Policymakers are forever fighting the war before the last war. During that crisis, in 1989, we introduced the Reserve Bank Act to fight the inflation of the 1970s, while ignoring the actual wreckage (unrelated to inflation) that was taking place around us.
It's now 2005, and we still haven't moved on. We are still trying to fight the inflation of the 1970s, and Dr Bollard has told us that, come hell or high water, he will keep raising interest rates until he's satisfied that he's won that war.
We are spending too much, says Dr Bollard. In particular, we are spending too much on housing and imported consumer goods. (The non-tradeable business sectors of the New Zealand economy are also almost certainly spending too much on imported investment goods such as machinery, given that the outlook for non-tradeable sectors like construction and retailing is much like it was in late 1987.)
The point that matters is not whether we are spending too much on these items, but why. Our spending on these items has dramatically increased in the last three years, and even in the last year. There has not been a change in our spending culture, as Dr Bollard implies in his speeches. Rather, the price signals that guide our spending have directed us to spend more on the things that Governor Bollard says we should not spend more on. Yet he's the one who has set those price signals.
Price signals are like traffic lights. Green means go. So does falling prices. By making the exchange rate go up, imports get cheaper. To consumers, a high exchange rate therefore equates to a green light. Further, Dr Bollard's words have fuelled expectations that the traffic light will next year turn to orange and then red. What do we do when we see a green light but fear that it will change to orange? We drive faster of course. By delaying the change to orange for over a year, consumers have been driving in a hurry all year.
Of course the Reserve Bank doesn't directly set the exchange rate. Rather it indirectly sets the exchange rate by directly setting interest rates. The green light on imports will only turn orange when the Reserve Bank stops raising interest rates. Only that will bring the exchange rate down. (There are also of course dangers if the light gets stuck on orange. After the orange we need a clear signal to switch spending in favour of New Zealand produced goods and services.)
At the time of the currency float in early 1985 we were told that, whenever our balance of trade went negative (ie import payments exceeding export receipts) then sales of the $NZ (to fund imports) would exceed purchases of the $NZ (repatriation of export earnings). So, by the basic laws of economics, the price of the $NZ would fall.
Last month, the trade deficit was nearly $900 million, about 7.5% of our GDP (gross domestic product) for the month. On top of that we are facing similar sized monthly deficits on interest and profits; payments such as the huge dividends Vodafone is paying its mainly British shareholders. Money has been gushing out of New Zealand. So the $NZ should have been falling. But no. Even more money has been flooding in. Not just coming in; flooding in.
There is one reason for this king spring tide in our nation's financial affairs. It is the high interest rates set by Alan Bollard. Foreign savers are saying "why should we accept low interest rates in our own countries when these generous New Zealanders are offering to pay us much more?". More importantly, foreign bankers are saying, "New Zealand banks are offering us good returns, so we will lend to them".
For most of 2005 the Reserve Bank's Official Cash Rate (OCR) has been settled at 6.75%, at a nice margin above Australia, and a bigger margin above Europe, Britain, North America and much of Asia. The market interest rate was steady at 7.00%, maintaining its usual margin over the OCR. (The Reserve Bank of Australia's cash rate has been 5.50% for 9 months, and has hardly changed over the last 2 years. Our's has climbed from 5% to 7% in that time.) Then something happened on September 15, two days before New Zealand's general election.
The Reserve Bank effectively promised to raise interest rates at the end of October. At the end of October the Bank did more than that. It hinted that the OCR would be raised to 7.5% (or more) in 2006. So, in anticipation, the money markets have already raised interest rates to nearly 7.7%, and it's still November 2005. An official rise in interest rates of one-quarter of a percentage point has expanded to a rise of two-thirds of a percentage point in the wholesale money market.
The $NZ is rising mainly because of the huge amounts of debt flowing from foreign financial institutions to New Zealand financial institutions. (The technical name for the process is arbitrage. New Zealand students who borrow at 0% and put their funds in a bank account at 5% will also be doing arbitrage. It's simply the opportunity to borrow at a lower rate and to re-invest at a higher rate.)
In many cases it's Australian banks that are lending to their New Zealand subsidiaries. They expect to gain both high interest and high dividends in 2006 as a result of these loans.
(We don't yet know to what extent these loans – at the end of this month - are denominated in Australian dollars or New Zealand dollars. We do know that the Argentine crisis of 2002 was substantially aggravated by the fact that similar debt was substantially denominated in $US, so when the Argentine peso plunged, the already high debts [when measured in pesos] sky-rocketed. We also do know that, in September, the foreign currency liabilities of New Zealand's registered banks was $53 billion, compared to foreign currency assets of $8 billion. We also know that, in September, 63% of non-resident liabilities were denominated in foreign currency, up from 56% last December.)
Why is the $NZ rising so much now against the $A? And why have residential property prices been falling in Australia but rising here? You work it out. It's not hard. And guess where the New Zealand banks are on-lending those Australian-sourced funds? Certainly not to businesses trying to compete in world markets with the handicap of a high and rising exchange rate to contend with. Of course most of these Australian funds are going into New Zealand real estate. See it from the banks' point of view. And the Australian banks are licking their lips at the prospect of an even bigger interest rate differential between the two countries in 2006.
The main difference between 2005 and 1987 is that there is no obvious foreign trigger this year. In 1987 New Zealand's domestic financial collapse was triggered by an overdue correction in the American sharemarket. America had a major correction in 2000-2002. It's not due for another correction now. The trigger this time, which will probably fire in 2006, may have domestic origins. Or it could be some unforeseen foreign event.
Long-term interest rates in New Zealand have not been rising. Rather, the money coming into New Zealand has been attracted by the short term rates. Much of it could leave within a month or two if its owners were to so choose. New Zealand's banks are borrowing short and lending long. The scene exists for a classic collapse of New Zealand's banking system; much like Australasia's worst-ever financial crisis, that of Victoria in 1893.
In 1988, the Australian parent banks baled out their failed New Zealand operations. As a result, these parent banks gained much more equity in the New Zealand banking sector. (Perhaps 90% of the equity in New Zealand's registered banks is now held by Australian banks.)
The danger for Australia is that a collapse in New Zealand's banking sector will trigger a crisis in the Australian banking sector. After all, Australia itself is facing similar problems: high interest rates; a high exchange rate; a significant balance of payments problem. Despite being a major creditor of New Zealand, Australia is significant as a debtor nation with respect to the rest of the world. Much more North American, European, British and Asian money is invested in Australia than in New Zealand.
Once world investor sentiment turns against New Zealand, it is likely to turn against Australia as well, both because the rest of the world tends to see New Zealand as a part of Australia, and partly because a bank collapse in New Zealand would represent a huge hit to the Australian banking system. (After all, the 1893 Australian collapse was triggered by a financial collapse in another country - Argentina. Northern hemisphere investors regarded Argentina and Australia as being connected in the sense that if investments were at risk in one, then they would be at risk in the other.)
The dangers New Zealand now faces were brought home to me when marking an essay. Students had to write about the financial crisis in Thailand (1997/98) or Argentina (2001/02). The stories they were telling about the events leading to the crises, especially that of Thailand, have so many parallels with New Zealand today. Further, the Thai crisis became an Asian regional crisis. I have suggested that our crisis will also be regional in scope.
Can we act now to prevent this crisis?
I believe we can, but it will be difficult. The first step will be, as stated in my introduction, to "stop digging" the financial hole that we are in. That means Governor Bollard must not raise interest rates on December 7.
The second step is for the government to negotiate a new Policy Targets Agreement (PTA) with the Reserve Bank. This agreement must de-emphasise the reduction of inflation and give priority to the balance of payments crisis that we face right now.
The government may also have to give further signals that it wants the exchange rate to fall in an orderly fashion. Possibly the best way to do that would be to impose a general tariff on imports. This would cause a one-off increase in inflation, but would also create an opportunity in a few years time to reduce inflation by progressively reducing that tariff. (The adverse impact of such a tariff on New Zealand's trading partners would be less than would an overly-rapid currency depreciation.)
We probably also need a sensible programme of tax cuts (ie not the recent ridiculous suggestion by Treasury to confine tax cuts to the two top rates, ensuring that the top 3% of income earners would get 50% of those cuts) that will ensure that New Zealand home-owners are able to meet their debts. As existing loans are repaid, and the $NZ falls back to sensible levels, then there will need to be some reforms (OK, "controls") to the banking system, possibly a quota that requires say 40% of bank lending to be to firms that either export or compete with imports.
I will conclude by noting that, deep down, we've never really believed that the balance of payments (or its subset, the trade balance) is less important than inflation. It only took rumours of a foot and mouth outbreak on Waiheke Island before the nation started to froth at its collective mouth. Well, the impact of foot and mouth disease on the country's balance of trade would be only temporary, whereas the impact on the balance of trade of high interest rates is possibly already greater in scope, and is potentially longer lasting. After all, land not farmed with sheep can be put to other uses. A high exchange rate caused by high interest rates creates a foot-and-mouth sized trade deficit, while denying New Zealand's producers the opportunity to reallocate resources into alternative export-focussed activities.
Keith Rankin - http://keithrankin.co.nz/